"We know too much, and are convinced of too little." -- T.S. Eliot
In this Information Age, when pages and pages of data on everything from ball caps to small caps can be accessed with a simple mouse click, finding time to sort through the information out there can be a daunting and time-consuming task. For the individual investor, knowledge is readily available through various online and offline sources. But true insight, particularly the kind of insight that leads to investing with conviction, remains exceedingly hard to find.
The Foolish 8 system imparts knowledge to the small-cap investor looking for investment opportunities. Taken as group, the Foolish 8 screens provide an efficient way to sort through the thousands of small publicly traded companies out there and generate a manageable list of prospects to research. However, the eight screens have no predictive power in and of themselves. They provide an initial dose of information to the investor, but little in the way of valuable insights that lead to an eventual investment decision.
The real insights, which are so rare in investing but are so fundamental to outperformance over time, come after the initial screening process is completed. But how are these insights to be discovered? Where should the small-cap investor look for them?
Here are some tips on what to do with the Foolish 8 list of small-cap stocks each month and how to start evaluating these companies on your own. Keep in mind that a small-cap winner will have three main elements going for it: It will be in a good business area, it will be a good company from an operational perspective, and it will sport a good management team. The Foolish 8 screens shed some light on these three topics, but more illumination is needed to reach a level of investing conviction. These are the questions that need to be asked in order to go beyond the initial chunk of fundamental business- and market-related information expressed by the Foolish 8 screens and gain real insights into a company.
Focus on good businesses
- What kind of margins and economic returns does the company make in its business? How can these items be increased in the future?
- What kind of margins and economic returns do the company's competitors make? If there are differences, what are the reasons for these differences?
- Are there more or less competitors in the industry today than there were three years ago? In the future, will there be more or less competitors?
- How fast is the industry growing, either in unit or revenue terms? Can the industry's growth rate be expected to accelerate or decelerate in the future?
- Has anyone in the industry been acquired within the past year? If so, who did the buying and what was the purchase price?
Focus on good companies
- Is the company gaining market share faster than its competitors? Why?
- How much money has the company spent in the last year to grow its business? Is it the lowest-cost operator in its industry?
- Does the company have a technological advantage? Is this advantage sustainable or could it be lost somehow to competitors?
- Can the company raise the prices of its products? Is it the firm that "sets" prices in the industry, or does it react to the price changes of its competitors?
- What would a competitor need to do in order to steal business away from the company?
Focus on good management
- Are management's interests aligned with shareholders' interests? How is management paid or incentivized?
- What are the areas that executives focus on day-to-day? What are the CEO's main responsibilities and interest areas?
- Has management been buying stock or selling stock lately?
- Where has management invested the company's free cash flow in the past three years? How have those decisions improved the company? Will free cash flows in the future be directed to the same areas or to different areas?
- What do competitors, customers, and suppliers say about the company's management? Do they have similar or conflicting views of the company?
Answering these questions will require research, deduction, and probably at least a few phone calls. No one said successful small-cap investing is easy. The Foolish 8 screens make small-cap investing simpler, but that's not the same as making it easy.
Small-cap investing has many elements to it that set it apart from other styles of investing. Starting on Tuesday, we'll delve into some of the issues that are unique to the small-cap investor in our regular Small-Cap Foolish 8 commentary. These once-a-week commentaries, which can be found in the Investing Strategies area of Fool.com, will strive to not only share knowledge relating to this investing style, but will search for genuine insights as well.
Until next week, Fool on!
[Motley Fool Research's Industry Focus 2001 features more on Foolish 8 small-cap stocks.]
More articles in this series:
Consider Cash Flow, 12/14/00
Price Is Fundamental, 12/13/00
Small Caps and Insider Holdings, 12/12/00
Small-Cap Fears, 12/11/00
Notes on the Margin, 12/8/00
Going With Growth, 12/7/00
Small Companies, Not Small Caps, 12/6/00
Small Cap Try-outs, 12/5/00
Buy Small, 12/4/00